Will the EU decide to double up?

A plan to combine the two eurozone bailout funds will be on the table at a meeting in Copenhagen this week. Ben Chu explains why

Ben Chu
Tuesday 27 March 2012 00:29

Two European bailout funds would be better than one. That's the view of many observers of the long-running eurozone sovereign debt crisis. And that's the reason pressure is rising for European finance ministers to "double up" when the meet in the Danish capital, Copenhagen, on Friday.

Here's how the plan would work: the temporary European Financial Stability Fund (EFSF), which has a €440bn (£388bn) lending capacity, is due to expire in June 2013. It is due to be replaced by a permanent European Stability Mechanism (ESM), with a lending capacity of €500bn, this summer. European leaders agreed to bring forward the establishment of the permanent fund last year in one of their many bids to calm the frenzied financial markets. So the new plan would be to keep the temporary fund in operation after this summer has passed and to run the two bailout pots in tandem. This would give the European bailout funds a combined firepower of €940bn.

That would then open the door for members of the International Monetary Fund (IMF) – who have made it clear that they will only increase their resources when the EU gets its own house in order – to boost the multilateral lender's lending power to €1trn. This would give investors the reassurance of total bailout resources to help prop up the eurozone of close to €2trn, unlocking confidence and investment.

So what's the obstacle? There are two. The first is politics. Germany, the country which is on the hook for the largest portion of both the bailout funds, has been resistant to the idea of running the two pots of money in parallel, because that would, inevitably, extend the scale of its own national guarantees to its southern European neighbours.

Berlin has, in fairness, given some ground on this. The German Chancellor, Angela Merkel, tested the water this weekend with a proposal for two funds to run in tandem only until the middle of next year. Ms Merkel is said to have calculated this is the maximum she could get past her parliament.

But it is not clear that such a time-limited plan would unlock the extra IMF resources. Other IMF members, particularly the US, might well judge that Europe is still not doing enough to warrant them increasing their own commitments to the multinational rescue fund.

That feeds in to the second obstacle: market credibility. A time limit on the tandem operation could be self-defeating. Many investors say they want to know that the eurozone, in co-operation with the IMF, has sufficient resources on hand to prevent member states the size of Spain and Italy from defaulting on their debts. The two countries between them make up more than 35 per cent of the eurozone bond market. The combined bailout fund would only just cover their financing needs over the coming years. Indeed, it might be too small. With €200bn committed from the EFSF to Greece, Ireland and Portugal, the true size of the combined funds would be €740bn rather than €940bn. Further, the ESM would revert back to €500bn in size in the summer of 2013. Investors, it is said, are looking for much longer-term security than that.

Or are they? The financial markets have actually been much calmer in recent weeks since the Greek bailout was agreed. The injection of around €1trn into the European banking system by the European Central Bank in recent months has successfully dispelled fears of an imminent major European financial crisis. Banks now have enough money to see them through the next three years.

This has fed through to greater confidence in sovereign debt. The 10-year borrowing costs of Italy and Spain have fallen dramatically from their peaks last November which were above 7 and 6 per cent respectively.

But some feel this central bank activism has resulted in dangerous complacency among politicians.

"The rally stems from a sense of relief more than anything else" said Nicholas Spiro of Spiro Sovereign Strategy. "The pendulum of sentiment has swung from paranoia to sanguinity bordering on complacency in the space of just four or five weeks."

Yet markets might be turning again. Spain's 10-year borrowing costs crept back up above 5.4 per cent last week as investors began to cotton on to the fact that its economy is shrinking and the centre-right government in Madrid is struggling to bring down the deficit.

Progress on Friday could be elusive because there is disagreement about what is concerning bond market investors. The European Commission's top economic official, Olli Rehn, said at the weekend that investors in Spanish debt are primarily concerned about slippage by the Spanish government on deficit reduction.

"Because there was a perception Spain was relaxing its fiscal targets for this year, there has already been a market reaction of several dozen basis points on yields of Spanish bonds," he told reporters at an informal gathering of European leaders in Finland.

Yet some analysts claim that the concern of investors is precisely the opposite: that austerity, demanded by the EU, is driving the Spanish economy further into the mire and making the need for a rescue (which the EU might not be able to afford) more likely.

"Spain is on the sharp end of the anxiety because of growing fears that its austerity drive has become self-defeating," said Mr Spiro.

Given all that, what should we expect from Copenhagen? Throughout this crisis, European leaders have done the minimum possible at every stage in the hope that it would prove enough. A combination of the two rescue funds is likely; a permanent bolstering of the eurozone's firewall is not.

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